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CURRENCY EXCHANGE RATE ASSUMPTIONS

U.S. dollar downtrend may be finally underway

Thushka Maharaj, D.Phil., CFA, Global Strategist, Multi-Asset Solutions Michael Feser, CFA, Portfolio Manager, Multi-Asset Solutions

IN BRIEF • Our long-held view that the U.S. dollar is on a secular downtrend now has a cyclical catalyst: the start of a new synchronized global business cycle. Our conviction in a USD downtrend is also driven by the dollar’s expensive starting valuation and relatively higher expected inflation in the U.S. than in the eurozone and Japan. • Should the U.S. pursue stimulative fiscal policy, and monetary policy focused on stoking inflation expectations, those actions would powerfully support reflation and growth, and an erosion in the dollar’s real value. • Developed market currencies’ bilateral relationships with the USD drive our views; above others, we expect the euro to serve as a more credible counterweight to the dollar and potentially to reassert its standing as an alternative reserve currency, boosted by the region’s pandemic recovery fund, which underscores the eurozone’s new economic solidarity. • We expect a wide dispersion among emerging market currencies and continue to expect the Chinese yuan to appreciate, albeit to a somewhat lesser degree than implied by its fair value. CURRENCY EXCHANGE RATE ASSUMPTIONS | U.S. DOLLAR DOWNTREND MAY BE FINALLY UNDERWAY

STRONGER CONVICTION IN THE CYCLICAL AND STRUCTURAL DEPRECIATION OF THE USD

The 12 months ended September 2020 saw the erosion of U.S. that builds on the PPP estimates for actual individual consumption, exceptionalism – in terms of its growth rate, its Treasury bonds’ as calculated by the World Bank and the Organization for Economic yield advantage and the magnitude of the economic fallout from the Co-operation and Development (OECD) for their international price restrictions required to contain the spread of the COVID-19 comparison program (EXHIBIT 2).2 pandemic. In sum, from a cyclical perspective, the starting point for the U.S. economy at the beginning of this new cycle is indeed To arrive at a given exchange rate projection over our assumption unexceptional vs. other countries’. horizon, which we also refer to as future fair value, we adjust today’s fair value exchange rate using the Long-Term Capital Market Our long-held view that the U.S. dollar is poised to enter a secular Assumptions’ (LTCMAs’) underlying macroeconomic assumptions, as downtrend now has a cyclical catalyst (EXHIBIT 1) – strengthening follows: For G10 currencies, we reflect the expected change in a our conviction that the necessary conditions for a longer-term USD country’s terms of trade over the assumptions horizon by adjusting depreciation have begun to fall in place as more symmetrical fiscal today’s fair value for the projected inflation rate differential between and policy responses across the regions start to tilt the relative the two countries. For emerging markets, we make an additional growth differential in favor of economies outside of the U.S. adjustment for the expected differential in GDP-per-capita growth.

Methodology Our assumptions continue to reflect the adverse impact of deteriorating demographics on developed market (DM) economies’ As in prior years, we have determined today’s fair value exchange growth prospects, expectations for smaller improvements in total rates for G10 1 currencies through a relative purchasing power parity (PPP) approach, based on the long-term average of each currency’s real exchange rate. To calculate the fair value for emerging market 2 According to the OECD, PPP for actual individual consumption covers all households’ currency exchange rates, we take an absolute PPP-based approach consumption expenditure and that part of government final expenditure that covers services it supplies to individual households – for example, housing, health, education, social protection, etc. It does not include government final expenditure on those 1 The Group of Ten in this context is Australia, Canada, the eurozone, Japan, New Zealand, services it supplies to households collectively, such as defense, police and environmental Norway, Sweden, Switzerland, the UK and the U.S. protection.

USD performance: Closely linked to relative growth differentials The fall in USD is largely driven by its high starting valuation between the U.S. and the rest of the world EXHIBIT 2: CYCLICAL AND SECULAR (INFLATION DIFFERENTIAL) EXHIBIT 1: U.S. VS. ROW GROWTH VS. USD REER CONTRIBUTIONS TO OUR 2021 CURRENCY EXCHANGE RATE ASSUMPTIONS

US-RoW 5yma REER-CPI RHS Cyclical - valuation e ect Secular change Total ppa change

1.0% 130 4%

3% 0.5% 120 2%

0.0% REER index 1% 110 0% -0.5% US – RoW growth -1% 100 -1.0% -2%

-1.5% 90 -3% ’86 ’89 ’92 ’95 ’98 ’01 ’04 ’07 ’10 ’13 ’16 ’19 USD EUR GBP JPY CHF CAD AUD BRL CNY MXN

Source: Bloomberg, World Bank; data as of March 2020. ROW: Rest of the world; REER: Source: OECD, J.P. Morgan Asset Management; data as of September 30, 2020. Ppa: real effective exchange rate; 5yma: 5-year moving average. percent per annum.

2 LONG-TERM CAPITAL MARKET ASSUMPTIONS | J.P. MORGAN ASSET MANAGEMENT CURRENCY EXCHANGE RATE ASSUMPTIONS | U.S. DOLLAR DOWNTREND MAY BE FINALLY UNDERWAY factor productivity3 and lower levels of human capital development inflation targeting.5 So we don’t expect the Fed to even think about over our forecast horizon (EXHIBIT 3). We project that emerging raising rates until it sees inflation clearly on track to exceed its markets, in aggregate, will grow faster than developed markets, longer-term target, following the new mantra: Do not fire until you given the anticipated larger increases in the size and quality of their see the whites of their eyes. To run the economy hot and above full labor forces, although with an increasingly wide dispersion in their employment for a prolonged period of time is not only acceptable labor force growth rates. The labor forces in some emerging under this policy stance but a necessity for its success. Policymakers economies, such as Russia and Korea, are likely to begin shrinking are clearly willing to tolerate a temporary inflation overshoot. As to in the coming years. whether they are actually able to generate higher inflation, the burden of proof will be on realized and actual inflation outcomes. Our assumption of a USD downtrend is driven equally by a number of factors: the U.S. dollar’s expensive starting valuation, improving A necessary ingredient for reflation and boosting inflation growth outside the U.S. and higher expected U.S. inflation, in expectations would be a pro-cyclical fiscal stimulus in the U.S. that particular relative to the eurozone and Japan.4 We expect remains expansionary well into the recovery. Indeed, we expect fiscal quantitative easing (QE) and excess USD liquidity to be dominant policy to be used as aggressively in this cycle as monetary policy was features of this new cycle, depressing the real rate advantage of the used in the previous one – as we highlight in two of the theme U.S. vs. its major trading partners. chapters in this year’s edition: on fiscal policy (in “The fiscal decade: The promises, problems and potential of fiscal stimulus”) and on high But in order to see an actual period of a weak dollar, U.S. realized and rising debt loads (in “Debt, debt everywhere: The implications of inflation and inflation expectations would have to rise above a high debt world”).6 Along with raising inflation expectations, we also the Federal Reserve (Fed) target and stay there for a sustained see this increase in fiscal spending and expanding of federal deficits period. as necessary ingredients for USD depreciation. While this should That may take a while. As we discuss in the Fixed Income suffice to weaken the dollar, it is not clear whether it will usher in a Assumptions section, we expect the Fed to adjust its policy reaction new era of a weak USD, given the currency’s continued dominance in function in this new cycle toward focusing explicitly on average global trade and finance.

5 The Fed’s policy up to now has been to target 2% inflation without regard for past periods in which inflation may have gone above or below that level. By contrast, with average inflation targeting, the Fed takes the past into account, so that if past inflation was below 2% for a period of time, it would aim to compensate with a period in which it 3 Total factor productivity (TFP) is a residual that in developed economies likely reflects is above 2%. technological change. It encompasses productivity growth not explained by capital 6 John Bilton et al., “The fiscal decade: The promises, problems and potential of fiscal stock accumulation or the labor force (increased hours worked) but rather captures the stimulus,” and Thushka Maharaj et al., “Debt, debt everywhere: The implications of efficiency or intensity with which inputs are utilized. a high debt world,” 2021 Long-Term Capital Market Assumptions, J.P. Morgan Asset 4 We downgraded our inflation assumptions for Europe and Japan last year. Management, November 2020.

Assumptions for selected changes in currency exchange rates vs. USD, nominal and real EXHIBIT 3: OUR LONG-HELD VIEW OF A SECULAR USD DOWNTREND HAS A CYCLICAL CATALYST IN THE NEW CYCLE

Spot 2021 2021 vs. 2020 assumptions % change p.a. 2020 assumptions assumptions September 30, 2021 Inflation Growth 2020 nominal 2020 LTCMA forecast nominal p.a. differential Real differential p.a. Change EUR 1.17 1.39 1.40% 0.70% 0.70% 1.90% -0.50% GBP 1.29 1.43 0.80% 0.00% 0.80% 1.50% -0.70% JPY 105.45 88.62 1.40% 1.30% 0.10% 1.70% -0.30% CHF 0.92 0.80 1.10% 1.50% -0.40% 1.50% -0.40% CAD 1.31 1.21 0.80% 0.20% 0.60% 1.20% -0.40% AUD 0.72 0.71 -0.10% -0.30% 0.20% 0.50% -0.60% BRL 5.61 4.97 1.00% -2.30% 2.70% 0.60% 0.60% 0.40% CNY 6.79 5.85 1.20% -0.50% -0.90% 2.60% 2.00% -0.60% MXN 22.11 22.04 0.00% -1.70% 1.00% 0.70% -0.80% 0.80% Source: Bloomberg spot FX, J.P. Morgan Asset Management; estimates as of September 30, 2020. P.a.: per annum. Spot FX rates are quoted using market convention; % changes p.a. are quoted uniformly vs. USD such that a positive number reflects appreciation vs. USD, and vice versa.

3 LONG-TERM CAPITAL MARKET ASSUMPTIONS | J.P. MORGAN ASSET MANAGEMENT CURRENCY EXCHANGE RATE ASSUMPTIONS | U.S. DOLLAR DOWNTREND MAY BE FINALLY UNDERWAY

While our core macro scenario calls for a weaker USD, we do also Trade-weighted indices (TWI) for the euro, pound sterling, yen and realize that the U.S. dollar continues to play a unique role in global yuan are not misaligned with one another; we focus on each trade and finance. As EXHIBIT 4 illustrates, even though the weight currency’s relationship with USD of U.S. GDP in global GDP fell from 32% to below 25%, the USD was EXHIBIT 5: TRADE-WEIGHTED INDEX, PER ANNUM CHANGE still a large weight in international FX reserves, according to 2021 2020 7 International Monetary Fund (IMF) data. We see this largely as a USD -1.04% -1.32% reflection of the noneconomic benefits and usage of the U.S. dollar EUR 0.57% 0.76% in trade and finance. This unique position in the global economy GBP -0.29% 0.02% and financial architecture is likely to act as a partial offset and limit the USD secular decline to less than what other fundamental data JPY 0.35% 0.31% may imply. CNY 0.51% 0.86% USD DXY -1.27% -1.77%

While U.S. GDP has fallen as a percentage of global GDP, USD still made Source: J.P. Morgan Asset Management; data as of September 30, 2020. up a large proportion of international foreign exchange reserves EXHIBIT 4: USD IN FX RESERVES VS. U.S. GDP IN GLOBAL GDP (% WEIGHT) USD - IMF COFER weight US – weight in global GDP7 MAJOR CURRENCY PAIRS

90% 40% The euro We expect the euro will be a key counterweight to USD. In the last 80% 35% cycle, the euro was dogged with sovereign debt default risk, a central bank reluctant to engage in QE, fiscal austerity and the 70% glaring lack of a centralized fiscal authority that could facilitate a 30% transfer from the rich northern countries to those in the south and 60% east. We see the announcement of the Next Generation European

25% Union (EU) recovery instrument and the coronavirus response 50% recovery plan as crucial components for establishing a more credible fiscal authority at the euro area level. Recovery funds, which will be 40% 20% used to support countries according to their level of structural ’69 ’74 ’79 ’84 ’89 ’94 ’99 ’04 ’09 ’14 ’19 unemployment and loss of growth due to the COVID-19 shock,

Source: IMF, J.P. Morgan Asset Management; data as of December 31, 2019. ensure that fiscal spending continues well after the recovery from the COVID-19 recession. The linking of the recovery fund to the EU’s seven-year budget is a bold innovation underscoring the solidarity Across DM currencies, it is the bilateral relationships with the dollar with which the EU is providing help for countries facing the that drive our FX views. As was the case last year, the trade- harshest challenges. weighted indices for EUR, GBP, CNY and JPY are not significantly Policymakers were well aware that this recession could be the misaligned vis-à-vis one another. Our assumptions therefore do not defining moment for the EU and that divergent recoveries afterward imply a significant loss in the relative competitiveness of any one could spell the end of the euro project. Crucially, the establishment of region vs. another (EXHIBIT 5). this recovery fund aims to restart economic convergence and catalyze increased prosperity for all EU members, not just a choice few.

The recovery fund’s spending plan and the institutional framework laid out to fund it set important precedents for how the EU may deal with future recessions, and form a blueprint for a truer and closer fiscal union – the closest we have seen since the 1999 inception of the euro. The plan also adds an alternative, euro-denominated safe haven asset to the market.

7 As measured by Currency Composition of Official Foreign Exchange Reserves (COFER), an official database managed by the International Monetary Fund.

4 LONG-TERM CAPITAL MARKET ASSUMPTIONS | J.P. MORGAN ASSET MANAGEMENT CURRENCY EXCHANGE RATE ASSUMPTIONS | U.S. DOLLAR DOWNTREND MAY BE FINALLY UNDERWAY

Essentially, this new framework removes the redenomination risk and are less concerned about the inflationary consequences. For a premium8 built into the euro, introducing the conditions for an era select number of countries, this concurrent fiscal and monetary of EU exceptionalism in terms of sustained growth and largesse is likely unsustainable, and economic reforms may well stall. transformation toward a more sustainable economic model. In those cases, we expect currency depreciation to be the main A depreciating dollar is crucial if the EUR is to behave in a less release valve to reequilibrate relative competitiveness. Hence, our cyclical manner and reassert its standing as a credible alternative forecasts are for the Mexican peso to remain above 22 in equilibrium reserve currency to the USD (EXHIBIT 6). and the South African rand to depreciate 1.2% annually vs. the USD. The Brazilian real, by contrast, appreciates by 1% per year.

We see conditions for EU area exceptionalism bolstering the euro’s The Chinese yuan ability to become an alternative reserve currency The Chinese yuan remains in its infancy as a reserve currency EXHIBIT 6: EUR WEIGHT IN IMF FX RESERVES VS. EUR PPP VALUATION (reserve managers hold 1%–2% of reserves in CNY), and it is hard EUR – OECD PPP valuation EUR – IMF COFER weight (RHS) % % to envisage its widespread adoption as an alternative to USD 40 30 without further liberalization of capital and trade markets.

30 28 Geopolitical tensions now appear to be less focused on currency manipulation or tariffs, but an ongoing headwind from Sino-U.S. 20 26 strategic rivalry remains a long-term theme. The area of most acute 10 24 tension has shifted toward tech dominance and strategic control of 0 22 resource-rich regions, which impact currency exchange rates less

-10 20 directly, but their persistence over time is a key reason we expect the CNY to appreciate less than its fundamental fair value would -20 18 imply (EXHIBIT 7). -30 16

-40 14 While still in its infancy as a reserve currency, the Chinese yuan’s Jan-99 Jun-04 Dec-09 Jun-15 Nov-20 weight in IMF FX reserves is higher than Australia’s and Canada’s Source: Bloomberg, IMF COFER; data as of June 30, 2020. EXHIBIT 7: CNY WEIGHT IN FX RESERVES (%) GBP YEN CNY CAD AUD Pound sterling

In the UK, sterling is driven in the near term by Brexit uncertainty. 1.7 We expect a trade deal by the end of 2020 but expect it to be 1.7 1.9 narrow, leaving a high degree of uncertainty. An agreement on a 1.9 2.0 2.1 trade deal is only the first of many steps in the journey to 1.9 1.8 1.8 establishing a new trading arrangement with the EU. Our forecasts 0.9 1.9 for a higher pound largely emanate from our secular view on USD 5.0 5.8 depreciation. This year, we reflect the narrowness of a trading 4.6 agreement and heightened uncertainty even after an agreement 4.0 is reached, with a higher haircut adjustment to the fair value for GBPUSD. 3.8 4.3 4.5 4.5

Emerging market currencies Q4 2014 Q1 2017 Q3 2018 Q2 2020 Our outlook for emerging markets moderates our assumption about Source: Bloomberg, IMF COFER; data as of June 30, 2020. the magnitude of the USD fall: Emerging economies would need to heal and recover strongly for a uniformly large dollar decline. What we expect instead is more likely a wide dispersion of outcomes. Our assumptions anticipate inflation remaining persistently high for certain Latin American countries and South Africa while falling further in Asian economies, including Korea and Taiwan. Emerging market central banks have started to engage in QE for the first time

8 Redenomination risk premium refers to the risk that a euro asset will be redenominated into a devalued legacy currency.

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